CHAPTER 6: PROBLEM SOLVING

Problem 1 (15 poin!"

Suppose you have invested in three stocks: A, B and C. You expect that returns on the
stocks depend on the following two states of the economy, with the probabilities to
happen given below.
State of
Economy
robability of
State !ccurrence
"eturn on
stock A
"eturn on
stock B
"eturn on
stock C
#oom $.%$ %& '(& ))&
#ust $.)$ )& )& *+&
a. (5 poin!" ,hat is the expected return of an e-ually weighted portfolio of these three
stocks.
b. (5 poin!" ,hat is the expected return of a portfolio invested /$ percent each in A and
B, and +$ percent in C.
c. (5 poin!" ,hat is the standard deviation of a portfolio invested /$ percent each in A
and B, and +$ percent in C.
Problem # (15 poin!"
#ased on the following information, calculate the expected return and standard deviation
of each of the following stock. 0ssume each state of the economy is e-ually likely to
happen. ,hat are the covariance and correlation between the returns of the two stocks.
State of Economy "ate of "eturn on stock A "ate of "eturn on stock B
#ear +.)& *).%&
1ormal '$.(& +.2&
#ull '(.+& /(.)&
a. (5 poin!" ,hat is the expected return on stock A and stock B.
b. (5 poin!" ,hat is the variance and standard deviation for stock A and stock B.
c. (5 poin!" ,hat are the covariance and correlation between the returns of the two
stocks.
Problem $ (15 poin!"
#ased on the following information calculate the expected return and the standard
deviation for the two stocks.
State of
Economy
robability of
State of Economy
"ate of "eturn
on stock A
"ate of "eturn
on stock B
"ecession $.'$ +& */$&
1ormal $.+$ %& ')&
#oom $.)$ ''& ))&
a. (5 poin!" ,hat is the expected return on stock A and stock B.
b. (5 poin!" ,hat is the variance and standard deviation for stock A and stock B.
c. (5 poin!" ,hat is of the standard deviation of an e-ually weighted portfolio of these
two stocks if the correlation is $./.
Problem % (15 poin!"
Consider the possible rates of return that you might obtain over the next year. You can
invest in stock U or stock V.
State of
Economy
robability of
State of Economy
"ate of "eturn
on stock U
"ate of "eturn
on stock V
"ecession $./$ %.$& *(.$$&
1ormal $.($ %.$& '$.$&
#oom $.)$ %.$& /(.$&
a. (5 poin!" 3etermine the expected return, variance, and the standard deviation for
stock U and V.
b. (5 poin!" 3etermine the covariance and correlation between the returns of stock U
and stock V.
c. (5 poin!" 3etermine the expected return and standard deviation of an e-ually
weighted portfolio of stock U and stock V.
Problem 5 (1& poin!"
Security A has an expected return of 4 percent with a standard deviation of '.( percent.
Security B has an expected return of '/ percent with a standard deviation of /.2 percent.
5he two securities have a correlation coefficient of $./$. 6f you invest 2$ percent of your
funds in Security A and +$ percent in Security B, calculate the expected return and
standard deviation of the portfolio. (1ote: change the calculator to + decimals"